Business Finance Online

Capital Budgeting


Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:

A Capital Budgeting decision rule should satisfy the following criteria:

  • Must consider all of the project's cash flows.
  • Must consider the Time Value of Money
  • Must always lead to the correct decision when choosing among Mutually Exclusive Projects.
Project Classifications

Capital Budgeting projects are classified as either Independent Projects or Mutually Exclusive Projects.

An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting critierion should be accepted.

Mutually Exclusive Projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.

Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable.

Cost of Capital

The firm's Cost of Capital is the discount rate which should be used in Capital Budgeting. The Cost of Capital reflects the firm's cost of obtaining capital to invest in long term assets. Thus it reflects a weighted average of the firm's cost of debt, cost of preferred stock, and cost of common stock.

Concepts

Tools and Problems

 

© 2002 - 2010 by Mark A. Lane, Ph.D.